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Dilantha De Silva
Dilantha De Silva
Articles (182)  | Author's Website |

Fed Stress Test Results and the Outlook for Banks

The policymakers delivered good news for value investors

December 21, 2020 | About:

Banks play an integral role in an economy by facilitating capital flows and overlooking payments. For this reason, the financial services sector is often considered as one of the most critical pillars to the success of a nation. The global financial crisis raised questions about the lending and investment practices of the global banking industry as several billion-dollar banks were bailed out by regulators to avoid a catastrophe. Following this event, the Federal Reserve introduced many precautionary measures to prevent adverse developments in the future, and the stress test results released by the Fed on Dec. 18 goes on to indicate the success of these regulatory changes. A careful evaluation of the notes from the meeting reveals good news for dividend investors.

The purpose of stress tests

Understanding the reasons behind the tests conducted by the Fed is important to properly evaluate the results. Economic recessions affect banks negatively in more ways than one. When the Fed engages in quantitative easing activities, such as reducing interest rates, the profitability of banks deteriorates as a result of a decline in net interest margins. On the other hand, loan loss provisions typically rise during an economic downturn as some customers default on their payments. Stress tests carried out by the Fed try to determine the profitability, revenue and capital level of major banks under extremely unfavorable conditions. The outcome of these results helps the Fed identify the changes certain banks need to implement today to avoid being the victim of a severe downturn in the coming months.

Below are some of the major macroeconomic data points the Fed takes into account to determine the strength of the banking system during a recession.

  1. Real GDP growth.
  2. Nominal GDP growth.
  3. Real disposable personal income growth.
  4. Unemployment rate.
  5. Inflation.

The first round of tests was carried out in June and the Fed found out that banks can withstand a major economic shock because of the strong liquidity of the industry. However, as a precautionary measure to help preserve capital, the regulator advised banks to abandon stock repurchase activities and dividend hikes.

Results of the second round of stress tests

The sensitivity analysis was carried out based on two different scenarios: severely adverse and alternative severe. The below is an illustration of the expected common equity tier 1 capital ratio of major banks in the most stressed scenario.

Source: Federal Reserve/American Banker

All of these institutions are in a strong position from a liquidity perspective to weather a significant slump in business activities in the next year. However, the global economy can be expected to grow in 2021, which is even better news for the banking industry.

Considering the results of this sensitivity analysis, the Fed delivered good news for dividend investors as well. Banks would be allowed to resume stock repurchase activities in the first quarter of 2021, but the maximum payout needs to be below net income for the trailing 12 months period. The rule applies to dividends as well. In summary, the total payout cannot exceed earnings in the past 12 months, which is an effective mechanism of restricting capital outflows from the industry while rewarding shareholders.

Following this development, JPMorgan Chase & Co. (NYSE:JPM) announced a $30 billion stock buyback program that would kick off in the first quarter of next year. Many other banks are likely to follow this lead. In a statement released to the market, The Goldman Sachs Group, Inc. (NYSE:GS) wrote:

"We are pleased that the results of the Federal Reserve's latest stress test demonstrate the resilience of the largest US financial institutions in the midst of a devastating pandemic. Based on the results and guidance from the Federal Reserve, we intend to resume share repurchases next quarter."

Commenting on the strength of the banking system, Fed vice chair for supervision Randal Quarles said:

"The banking system has been a source of strength during the past year and today's stress test results confirm that large banks could continue to lend to households and businesses even during a sharply adverse future turn in the economy"

These are promising signs as the financial services industry has always been one of the most favorite business sectors for value investors. However, investors still need to consider various macroeconomic factors before reaching an investment decision.

Formulating a strategy

The positive outcome from the stress tests suggests the Fed has done a tremendous job in safeguarding the U.S. economy from a crash that could wipe out billions of dollars of investor money. However, this is not an investment thesis in and of itself.

The ultra-low interest rate environment is likely to prevail through the end of 2022, which was confirmed by Fed Chair Jerome Powell in November. This is bad news for the industry as profit margins will remain under pressure until there is a significant increase in rates. Due to limited earnings growth, it would be difficult for banks to hike dividends and buybacks since the Fed has now capped the total payout ratio at the net income available to common shareholders. Investors who are primarily focused on growth are likely to find better opportunities in other business sectors.

In comparison, value investors with an extensive investment time horizon should find the banking industry appealing. As illustrated below, the financial services sector is trading at a significant discount to the market from a Shiller P/E perspective, which is always a sign that there could be value opportunities in this sector.

Source: GuruFocus

The market is not cheap and finding good opportunities can be difficult as a result. Banks offer a good opportunity for patient investors who are willing to expect returns in line with the broad market for at least another couple of years. As the U.S. economy reaches maturity once again, which could be a few years down the line, banks are likely to deliver alpha returns as inflation will head higher, prompting policymakers to hike interest rates.

Empirical evidence also suggests that now is a good time to invest in banks. Below is an excerpt from an article that appeared in the Journal of Banking and Finance in August:

"We investigate the effects of the announcement and the disclosure of the clarification, methodology, and outcomes of the U.S. banking stress tests on banks' equity prices, credit risk, and systemic risk. We find evidence that stress tests have moved stock and credit markets following the disclosure of stress test results. We also find that banks' systematic risk, as measured by betas, declined in nearly all years after the publication of stress test results. Our evidence suggests that stress tests affect systemic risk."

According to the findings of the Journal, the risks of investing in the banking sector is likely to decline in the year ahead, which sets up a good platform for opportunistic investors.

Takeaway

The banking sector is trading at cheap valuation multiples and the second round of stress tests confirm the strong liquidity position of the industry. Even though the net income of many banks is unlikely to grow at stellar rates in the next couple of years, value investors can find lucrative opportunities in this space, especially considering the expected return of buybacks and dividend hikes in the first quarter of 2021.

Disclosure: The author does not have any shares mentioned in this article.

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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I\\\'m a CFA level 3 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). I am a registered candidate for the Chartered Wealth Manager program as well. During my free time, I enjoy reading.

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